So what do we mean by Return on Investment or ROI? It’s a phrase that tends to be thrown around in professional circumstances but often with different interpretations.
Recently, I’ve even noticed marketing people use it to compare the revenue generated to the cost of a campaign, whereas financial analysts have more options (and acronyms) at their disposal: Return on Assets (ROA), Return on Capital Employed, Return on Equity (ROE), Return on Total Capital (ROTC) to list a few.
The key thing for these ratio (or spot) based calculations is that you understand the inputs and that you’re comparing like with like and whether the ROI is based on the asset itself or on the equity invested (i.e. a leveraged or geared return dependent utlising debt).
In simple terms, ROI attempts to measure the return or profitability of an investment as follows:
ROI = (Income + Capital Gain) / Cost of Investment
This is effectively how our return on investment calculator works on the property profile page. It is meant as a guide to highlight the returns on the underlying asset versus the leveraged equity based return.
It’s also worth noting that if every investment followed the same hold period and cash flow profile then these ratio based calculations would go a long way to providing us with the information we need to make an investment decision. However, life is never that simple and understanding how the cash flow profile effects your return is important. When will cap ex be required, income increase or fall, what void periods are likely, is refinancing an option, what’s the anticipated hold period?
Then there’s the question of quant, would you rather have a 15% ROI on £100k or 13% on £120k?
This is investment appraisal territory requiring discounted cash flow (DCF) modelling to provide you with an Internal Rate of Return (IRR) or Net Present Value (NPV) of your property investment. They take into account an explicit allowance for certain events and allow for more accurate comparison between investment options.
An Example of a Discounted Cash Flow (DCF) Appraisal